Bollinger Bands are simply moving average bands with a volatility filter. However, it is that volatility filter that makes this one of the more valuable and popular technical indicators in use today.
The bands will bracket the market moves but in times of high volatility, they widen, while in times of low volatility, they move closer together. So basically, they adjust to the movement and volatility of the market. This extra volatility filter is the real value of this tool.
There are two situations we look for in a trading opportunity. We want to buy a pullback down to support when the market is in an uptrend or sell a rally up to resistance when the market is in a downtrend. The Bollinger Bands typically offer good resistance and support for our trade setup, so we just have to make sure we are following the strong trending markets. Let’s look at an example on this EUR/USD daily chart.
The trend is down as we see a series of lower highs and lower lows, which means to look for a rally up to resistance for a selling opportunity. I have one example noted on the chart that took place in January of this year. The market rallied up to the upper Bollinger Band and touched it twice as noted by the first two candles in the box. But I think that this is not necessarily the sell but rather just the signal to look for a sell on a reversal. Traders will use a variety of methods to determine the entry, ranging from using their favorite indicator to just selling as the market moves down through the previous low. One popular approach is to sell on the first candle that closes lower than the middle line, which is a 20-day Simple Moving Average. This serves as confirmation of the reversal and increases our chance of success on the trade. Traders could then place their protective buy stop above the high and look for twice that risk in profit for a 1:2 risk:reward ratio.
I would also like to point out that the EUR/USD moved up to touch the upper Bollinger Band today which does mean to look for a selling opportunity. But rather than just selling, now would be the time to use your approach to pinpointing that sell entry to increase your chance of success on the trade. The idea is the let this move up play out and get in after a reversal. Being early does not always mean being right, so look for a reversal before selling. Waiting for that first close below the 20-day Simple Moving Average is just one way to do this.
Written by Dailyfx.com